So, we know that contributions both to IRAs and 401(k)s are usually pre-tax dollars, but these plans may also be set up to take post-tax dollars, termed Roth contributions. Since Roth contributions are taxed before their deposit into the account and included in gross income, distributions at retirement are not taxed and contributions cannot be deducted on your tax return.

In the case of Roth 401(k)s, (or 403(b) plans) a separate designated Roth account is set up to receive the contributions that the employee designates as Roth contributions. Only elective contributions may be designated as Roth contributions. Employer contributions are still deposited into the employees pre-tax 401(k) account. All limitations and regulations that apply to the pre-tax 401(k) plan also apply to the Roth contributions.

IRAs – Individual Retirement Accounts or Individual Retirement Annuities
An Individual Retirement Account is an IRS approved trustee or custodial account (set up by a bank, federally insured credit union, savings and loan association, or other approved entity). An Individual Retirement Annuity is purchased from an insurance company. Both require that distributions begin by April 1st of the year following the year you turn 70 1/2. Contributions of more than the deductible amount ($5,000 for 2010 or $6,000 if you are over 50 years of age) or more than your taxable income cannot be accepted, except in the case of rollover contributions or employer contributions to a SEP-IRA. Also deductions begin to be phased out if your Adjusted Gross Income is between $89,000 and $109,000 for those Married Filing Jointly and $55,000 to $65,000 for those filing Single or Head of Household.

For more information on IRAs see Rebuilding Your Nest Egg – Parts 1 and 2.

Profit Sharing Plans
A Profit Sharing Plan is a defined contribution plan under which the plan may provide, or the employer may determine, annually, a fixed amount (for example $10,000) that will be contributed to the plan (out of profits or otherwise). Then a formula is applied to the amount to determine the portion that will be allocated to each plan participant. Contributions need not be a specific percentage of profits and they need not be made every year, as long as they are “recurring and substantial.” Profits are not required in order to make a contribution.

Up to 25% of covered payroll can be contributed and deducted by the employer. Plan contributions are normally based on total compensation; e.g., base salary, bonuses, overtime, etc. The maximum compensation recognized in 2009 and 2010 is $245,000. Since the employer already contributes to the employee’s Social Security retirement benefit, these contributions can be integrated into the allocation formula of the plan. The allocation of contributions to a participant’s account from all of the employer’s plans may not exceed the lesser of 100% of includable compensation or $49,000 per year.

In Part 5, we will look at the benefits and disadvantages of profit sharing plans both to the employer and employee and when in particular are these plans recommended.

There are basically 3 types of 401(k)s and an automatic 401(k) feature that may be applied to any of these.

Traditional 401(k)
With a traditional 401(k) plan the employer decides whether or not the company will contribute to the plan and may contribute a percentage of each employee’s compensation to the employee’s account (called a nonelective contribution), or may match the amount employees decide to contribute (within the limits of current law) or may do both. The employer may also have the flexibility of changing the amount of nonelective contributions each year, according to business conditions.
If the employer does contribute to the plan a vesting schedule may be applied for employer contributions.
These plans are subject to annual nondiscrimination testing to ensure that the amount of contributions made on behalf of rank-and-file employees is proportional to contributions made on behalf of owners and managers.

Safe Harbor 401(k)

Under a safe harbor plan, the employer must match each eligible employee’s contribution, dollar-for-dollar, up to 3 percent of the employee’s compensation, and 50 cents on the dollar for the employee’s contribution that exceeds 3 percent, but not 5 percent, of the employee’s compensation or may make a nonelective contribution equal to 3 percent of compensation to each eligible employee’s account.
All employer contributions are 100% vested and the plans are not subject to annual nondiscrimination testing.

SIMPLE 401(k)

Employer contributions to a SIMPLE 401(k) plan are limited to either a dollar-for-dollar matching contribution, up to 3 percent of pay; or a nonelective contribution of 2 percent of pay for each eligible employee.
No other employer contributions can be made to a SIMPLE 401(k) plan, and employees cannot participate in any other retirement plan of the employer. All employer contributions are 100% vested and the plans are not subject to annual nondiscrimination testing.

For a plan to qualify as an Automatic 401(k) the following conditions must be true.

Initial automatic employee contribution must be at least 3 percent of compensation. If initial employee contributions are less than 6 percent they must be set to automatically increase so that, by the fifth year, employee contribution is at least 6 percent of compensation.

Employee contributions are limited to $16,500 for 2009 and 2010 with an additional catch up contributions allowed of $5,500 for participants 50 and over.

Employer contributions must be at least a matching contribution, up to 1 percent of pay and a 50 percent match for all salary deferrals above 1 percent but no more than 6 percent of compensation; or a nonelective contribution of 3 percent of pay to all participants.

In part 4 of our series we will examine Roth plans, Profit Sharing Plans and the New Comparability Profit Sharing Plan.

Part one of this series addressed a type of Defined Contribution Plan (DCP) created particularly for individuals and small business owners – IRAs or Individual Retirement Accounts. Now we’ll discuss another Defined Contribution Plan which is probably the most widely known, 401(k) plans.

A 401(k) Plan is a plan set up by an employer which allows employees to defer a portion of their salary, before taxes, to a retirement account. As with IRAs, the funds and interest on the funds, accrue untaxed until distributed upon retirement.

There are some major differences however, some of which are listed below:

With an IRA all contributions are 100 percent vested, however some 401(k) plans may use a vesting schedule, meaning that employer contributions belong to the employee only after a specified number of years.

A 401(k) allows greater access to funds by permitting the employee to take loans from the funds which must be paid back.

In 2009 and 2010, employee contributions are limited to $16,500 annually with an additional $5,000 allowed if participant is over 50, while IRAs are limited to $11,500 with an allowed catch-up contribution of $2,500.

401(k) plans may be subject to annual nondiscrimination testing to ensure that the amount of contributions made on behalf of rank-and-file employees is proportional to contributions made on behalf of owners and managers.

IRAs are easier to set up and operate and do not require filing an annual return.

As the economy improves (think positive) small businesses should be looking again to provide employees with benefits that will ensure their best workers are with them for a long time to come. Health insurance aside the benefits most workers are anxious for are retirement benefits. However, for small business owners choosing and implementing the best retirement plan for the business can be a complicated and time consuming project, so for the next few blogs I will address some of the options available for retirement, the basics you need to know, as a small business owner, and advantages and disadvantages you may want to consider.

First we’ll discuss qualified plans, that is, plans which by definition qualify for tax-preferred treatment by the federal government, usually in the way of tax deductions or credits. When comparing the way in which benefits are determined, there are basically two groups, Defined Contribution Plans and Defined Benefit Plans.

With Defined Contribution Plans the benefit received by the participant depends upon the account balance of the participant when the funds are distributed and the plan itself defines the how contributions are made to the participant’s account.

One class of Defined Contribution Plans is Individual Retirement Accounts or IRAs. IRAs enjoy the following features:

Easy to set up and operate,

No annual return required,

Annual nondiscrimination testing not required, and

Immediate vesting of all contributions.

Discrimination testing ensures that the amount of contributions made on behalf of rank-and-file employees is proportional to contributions made on behalf of owners and managers, while vesting refers to employee ownership of the contributions. If contributions are 100% vested, the full amount is accessible to the employee (minus of course taxes due and a 10% penalty if withdrawn before retirement age). If employer contributions are vested according to a vesting schedule then if the employee terminates employment before completing a set number of years (according to the vesting schedule) the employee forfeits a portion of the employer’s contributions to the account. The forfeited amounts are then divided up among the remaining accounts.

A Simplified Employee Pension Plan (SEP) is an IRA that allows employers the option from year to year to make contributions on a tax-favored basis to IRAs of their employees. The employee must set up the IRA to accept the employer’s contributions and all eligible employees must participate in the plan, including part-time employees, seasonal employees, and employees who die or terminate employment during the year.
Sole proprietors, partnerships, and corporations, including S corporations, can set up SEPs. Administrative costs are low and employer may be eligible for a tax credit of up to $500 per year for each of the first 3 years for the cost of starting the plan.

The SIMPLE SEP has the same features as the SEP IRA except the employer must make either matching contributions or contribute 2% of each employee’s compensation. Also the plan must be offered to all employees who have earned income of at least $5,000 in any prior 2 years, and are reasonably expected to earn at least $5,000 in the current year.